SEC, Banks discuss CDO settlement

Banks in Talks to End Bond Probe

U.S. securities regulators are in preliminary discussions with several major Wall Street banks aimed at reaching settlements to resolve a broad investigation of their sales of mortgage-bond deals that helped unleash the financial crisis, according to people familiar with the matter.

The probe involves complex pools of mortgages and other loans called collateralized debt obligations, or CDOs, slices of which were sold to different investors.

Wall Street has come under intense fire from critics for its sale of the securities, seen as a central factor in the crisis. Settling the allegations would resolve one of the biggest law-enforcement threats hanging over leading banks.

The Securities and Exchange Commission, after issuing subpoenas for documents and interviewing officials from nearly every bank that was a major player in creating, selling or trading CDOs, has begun negotiating with the companies, these people said.

The talks are at early, informal stage and could fall apart, people with knowledge of them cautioned, especially as the banks and SEC wrangle over settlement terms.

Still, the move to try to work out deals with each bank is a sign of interest by all sides in ending the probe without a rerun of the public fight between the SEC and Goldman Sachs Group Inc. Goldman agreed in July to pay $550 million to settle SEC civil charges that it misled investors by not disclosing that it manufactured one CDO with input from a hedge-fund client that planned to bet against it.

Firms that received SEC subpoenas include Citigroup Inc., Deutsche Bank AG, J.P. Morgan Chase & Co., Morgan Stanley and UBS AG. None has been charged as a result of the investigation. A spokesman for the SEC wouldn’t comment.

Banks churned out more than $1 trillion of CDOs. They often created them at the request of investors who made bets against the deals. Some banks made their own bearish bets. Such bets paid off when the mortgage market crashed, though financial firms also suffered steep losses from CDOs stuck on their books.

Shortly after suing Goldman over a CDO deal in April, SEC enforcement director Robert Khuzami said the agency would look closely at deals similar to Abacus 2007-AC1, the one at the center of that suit. People close to the probe say it has become a top enforcement priority as the SEC pushes to show it is holding Wall Street accountable.

The investigation is homing in on a range of possible conflicts of interest. For instance, investigators are looking at how the assets in the CDOs were selected and valued, including how much influence particular hedge funds may have had in the selection, and when such funds may have been betting against those assets, people familiar with the matter said.

Among the CDOs being scrutinized are some invested in by Magnetar Capital, an Illinois hedge-fund firm. One of these is a $1.1 billion deal sold by J.P. Morgan in early 2007. Other CDOs being looked at include a $1 billion deal by Citigroup in 2007 called Class V Funding III.Citigroup, J.P. Morgan, UBS, Deutsche and Morgan Stanley declined to comment. Magnetar, which like the banks hasn’t faced any charges in the probe, said it has cooperated with requests for information. “We are not aware that this inquiry is focused on any particular person or firm, or on any particular group of transactions,” a spokesman said.

The Goldman settlement fueled speculation it could be a template for an industry-wide deal. Goldman conceded a “mistake” in not disclosing the full role of Paulson & Co. in the Abacas CDO. Goldman also agreed to toughen oversight of mortgage securities and employees who create or sell them. Paulson wasn’t accused of any wrongdoing.

An industry-wide strategy was followed by regulators in their crackdown over the earlier mess involving auction-rate securities, long-term debt instruments whose interest rates are reset periodically at auctions. After that market froze in the financial crisis, regulators alleged the investments were wrongly sold as safe and liquid, and later reached agreements with Citigroup, UBS and Merrill Lynch—now part of Bank of America Corp.—to buy back more than $36 billion of securities. Those deals became the framework for settlements with other banks. But the practices used by banks in manufacturing and pitching CDOs aren’t similar enough to make an industry-wide settlement possible, say people familiar with the situation. Morgan Stanley disclosed when creating CDOs that its own traders could bet against the deals, people familiar with the bank said. That is a different situation from the conflict the SEC alleged in the Goldman suit, involving failure to disclose a hedge fund’s role.

The degree of disclosure varied between CDO deals, as did the role played by investors betting against the housing market. Because of the differences, SEC officials are aiming to reach individual settlements with banks, the people familiar with the situation said. It isn’t clear when formal settlement talks could begin, or whether the SEC will demand fines or restitution to certain investors. Also unclear is the potential effect of any settlements on a related criminal probe launched earlier this year by the U.S. Attorney’s office in Manhattan. Officials there declined to comment.

At least some companies under SEC scrutiny are inclined to settle because of the pounding Goldman’s shares took after suit against it was first filed, said people familiar with the matter. Goldman fought the case for three months, repeatedly saying it had done nothing wrong and would prevail if the lawsuit went to trial. Some officials at other banks favor a settlement because any damage from a deal likely would be less-drawn out than the Goldman suit, according to people familiar with the situation. Goldman employee Fabrice Tourre still is battling civil-fraud charges filed against him by the SEC.

Another important factor in the probe is the concept of suitability—or the degree to which the CDO products were an appropriate investment for clients. In general, CDOs were sold more frequently to less-sophisticated investors as the market matured in 2006 and 2007.